See You in Omaha 2011 and Excerpts from Quarterly Letter

It
is time again for the annual trip to Warren Buffett’s Omaha to Berkshire
Hathaway annual meeting. Warren Buffett over the years was turned into
god. He is an incredible investor, brilliantly smart, full of worldly wisdom;
but, like everyone else, he gets up in the morning and puts his pants on one
leg at a time, and not everything he says is the ultimate truth, and not
everything he does is flawless (think Sokol/Lubrizol affair). He is very
much human. So I am not going to Omaha to worship, but to listen and to
learn. Though 90% of what I’ll hear I’ve heard before, it is a great time
to recharge the value investing battery. But I’ll be completely honest,
this weekend is not about Buffett or Munger – you could read the transcripts that
will capture everything Buffett says in minute detail, in a few hours on the internet
after the meeting. No, this is a weekend when I get to spend three days
with like-minded people – that’s why I’ll be there.

12:30
to 3 pm on Friday. I’ll hold my third annual CheapTalk – You are Invited! It will be held on the campus of Creighton
University at Billy Blue's
Alumni Grill (you can find directions here).
This is the same place where we held it last year. As always, nothing
fancy, water and thoughtful conversation. It should be a lot of fun.

3:30
to 5 pm on Friday, I’ll participate on the Third Annual Value Investing Panel,
hosted by Creighton University, with my friendWhitney Tilson (T2 Partners), Patrick
Brennan (partner at RBO & Co), Michael Green (owner of Evergreen Capital and
Management in Omaha); and the panel will be moderated by Mark Mowat (managing
director at Frontier Capital LLC). It is basically down the hall from Billy
Blue’s Alumni Grill. Last year the panel was followed by drinks and food (not
sure if that will be the case this year). Here is a link to the brochure.

6
to 8 pm on Friday. Book signing with a lot of interesting authors,
including two of my favorites, Jeff Matthews of Pilgrimage to Omaha fame and Pat Dorsey (The Little Book that Builds Wealth), and a
very long list of other good authors (you can find more information here).
Note that the location has changed from the Dairy Queen to Mammel Hall,
at the corner of Pine and 67th Street on the University of Nebraska at Omaha
campus.

I
am taking a 7am flight out of Omaha to Denver on Sunday, meeting my wife at the
Denver airport, and taking a flight to Amsterdam (just the two of us!).
We’ll spend two days in Amsterdam and then drive to Den Haag, Bruges, Brussels,
and Frankfurt (it’s only a 400-mile drive). I’ll give a talk on Friday in
Frankfurt, then we’ll take a train to Prague, spend the weekend there, and fly to
NYC.

I’m
giving a speech at the Hard Assets conference in NYC on May 10th (admission is FREE with pre-registration). My brother-in-law
will fly out our two adorable children, who will be missed dearly by that time,
and we’ll all spend a few days being tourists in NYC. I’ve been to New
York many times but never been to the Statue of Liberty.

I’d also like to share excerpts from our quarterly letter we send to
our clients (this is Part 1; I’ll share Part 2 in a few weeks). I’m
not sharing the full letter for a simple reason: we are still accumulating
shares in some stocks mentioned in the letter.

Purchase
of Big Lots

Big
Lots (BIG) is a closeout retailer with about 1,400 stores in the US. If
you visit one of their stores, you’ll probably be less than excited about this
purchase. But don’t be discouraged – you are not BIG’s target customer,
as it caters to lower-income, cash-strapped consumers who are looking for
ultimate bargains in household items and care little about ambiance. In
fact, soon after we made this purchase, a client mentioned that his wife would
never shop at Big Lots. Our “clever” response was, we bought BIG so she
would not have to. As investors we have to realize that, though it is
easier to buy stocks of companies whose products and services we use, that is
not always going to be the case.

BIG’s
stores were poorly managed until arrival of new CEO Steven Fishman about six
years ago. He completely transformed the company. Every single
operating metric from margins to inventory turnover to return on capital
improved substantially. Mr. Fishman refused to open new stores, he argued
real estate prices were too high (instead he focused on improving existing stores).
This is exactly what we want to hear from a CEO: he is not focused on growth
for growth’s sake, but wants only profitable growth with return on
capital well in excess of its cost. Today, after a severe recession and a
few high-profile bankruptcies – Circuit City, Borders, Linens ’n Things – BIG
is able to find real estate at prices that make economic sense. It will
open about 90 stores this year.

BIG
has a debt-free balance sheet. It doesn’t have to do much to achieve
reasonable low-double-digit earnings growth: about 3% will come from opening
new stores and another 1-3% from same-store sales; their profit margins are
still below their competitors’, so they have some room to expand, contributing
a few percentage points to earnings growth a year; and finally, management was
not shy about buying back stock with its ample cash flows. At the time we
purchased the stock in the majority of our accounts it was trading at about 10
times earnings.

In
early March, to our surprise, rumors circulated that BIG put itself up for sale
and hired Goldman Sachs as an advisor. The company would not comment on
rumors, a common practice. The company’s stable and growing cash flows
and debt-free balance sheet make it a likely candidate for a private-equity
buyout. In our estimate, if the company is taken private it will
be done at about $55-60 a share.

Purchase
of Abbott Labs (ABT)

We
owned ABT in the past, and were patiently waiting for the opportunity to own it
again. Think of ABT as a smaller version of Johnson & Johnson (without
weekly product recalls – we’ll touch on that issue later in the letter) – a
diversified healthcare company that makes pharmaceuticals, children’s formula,
stents, diagnostic products, etc. ABT is very similar to other
super-high-quality companies in our portfolio (we own plenty of that kind): it
is being OVER-penalized for its overvaluation in the late ’90s (see attached
article on Cisco where Vitaliy expands on this). At the time of the
purchase ABT was trading at a little bit less than 10x times earnings (in the
late ‘90s it was sporting a P/E close to 30x). ABT has high return on
capital, terrific management, reasonable amount of debt (especially considering
the stable nature of its cash flows) it can pay off its debt within two years if
it decides to do so, and it has almost 4% dividend yield. Over the last
decade ABT’s earnings per share have almost tripled, and though we don’t expect
that to happen, we still think it can comfortably grow earnings in high single
digits.

Purchase
of BP

The
Japanese tragedy has made global society question the safety of nuclear
energy. Already, Germany is “temporarily” suspending nuclear reactors,
will likely shut down older ones, and is stress testing new ones for
earthquakes and terrorist attacks. China has suspended approval of new
nuclear power plants. Nuclear energy is not going away anytime soon;
however, getting approval for new reactors will become a more difficult and
time-consuming process. We believe this will increase demand for other
sources of energy, natural gas in particular.

We
looked at energy names and found BP to be the most logical choice. Though
we still have the vivid images of the sunken Deep Horizon rig and gushing oil
from the Macondo well in the Gulf of Mexico, the well is capped and the impact
on nature appears to be a lot less than everyone feared. We did not buy
BP in the midst of the crisis, because it was very hard to estimate the
longevity of the problem and the impact it would have on the environment and
thus on BP. We bought Total instead, at the time. It had declined
as much as BP and had no significant exposure to the Gulf of Mexico. A
year later, though BP stock is up from lows it hit at the height of the crisis;
it is still down substantially from its highs.

BP
will continue to pay for losses, but these expenses appear to be very
manageable, running a few billion a year (you have to take this statement in
the context that BP has revenues of over $300 billion and profits in excess of
$20 billion).

Over
the last few months BP reinstated the dividend it suspended last year, and the
yield today is slightly less than 4%. The stock trades at about 7 times
earnings. BP’s leverage is not alarming (it can pay off its debt in one
year), but management has announced they want to reduce it further. Today
BP’s stock is still tainted by the Macondo spill – its significant discount to
its competitors clearly reflects that (Exxon, for instance, trades at a 70%
premium to BP), but as time goes by and memories of the spill fade, the
discount to peers will shrink.

Johnson
& Johnson – why we still own it

J&J
is probably one of the most respected companies in the United States, thus it
is the last company you’d expect to recall a product every other week – it has
recalled 22 products since September 2009. On the surface it appears that
J&J lost control over its manufacturing, doesn’t care about its customers,
and that the old white-glove J&J is gone. At least that is what the
headlines would have you believe. But if you carefully look at the nature
of the recalls you’ll see that quite the opposite is true. The majority
of recalls came from the US consumer division McNeil, the one that
manufactures Tylenol, Motrin, and some other well-known drugs. J&J
had manufacturing issues at that plant that ranged from (nontoxic) chemicals
used to clean wooden pallets leaking into the bottles and creating nauseating
odors, to metal and wood particles found in packaging. J&J closed the
McNeil plant a year ago, and went back and inspected products it manufactured
at the plant over the previous year or so. In typical J&J fashion, it
erred on the paranoid side (as it should) and recalled almost everything under
the sun that this plant manufactured. So the recalls we are hearing about
in the news are of products that were manufactured quite a while back. It
is important to understand that even after the McLean manufacturing problem has
been put to rest, J&J will still have an occasional recall. J&J
is a giant healthcare conglomerate, making everything from Band-Aids to
stents to medical equipment to artificial hips. Though it would be ideal
if it had zero recalls, humans will make mistakes, and the more products you
make, the higher the likelihood of mistakes.

The
recalls have hurt J&J, as revenues in the US consumer business have
experienced double-digit declines; however, this segment represents only 8% of
total revenues. J&J is not a broken company; its brand is so strong
that it is unlikely to be tarnished by these recalls – aside from discomfort,
the faulty products issued caused few problems, and certainly no fatalities.
J&J has a pristine, cash-rich balance sheet, double-digit return on
capital, dividend yield of 3.6%, and is trading at about 12 times
earnings. We believe our patience will be rewarded.